Bond turmoil threatens to trigger year-end global market sell-off

Reuters

By Jamie McGeever and Vikram Subhedar

LONDON (Reuters) - If October's bond jolt reverberates through a politically nervy end to the year, many funds fear it may trigger an exodus from all richly valued financial assets as investors re-price intertwined stocks and bonds and hurry to protect 2016 gains.

Record low bond yields have snapped higher suddenly this month as investors sense a shift away from ever-easier money and credit policies from the world's big central banks toward more use of government tax cuts or spending to foster growth.

According to a Bank of America Merrill Lynch survey this week, global fund managers say the biggest driver of world stocks over the next six months will be U.S. bond yields. Three quarters of those polled said Treasuries are too expensive.

The pop in yields, which rise as prices fall, comes as investors struggle to make sense of populist politics across much of the developed world and how it may affect governments and central banks, increasingly desperate to boost growth.

Potential turning points are scattered through the political diary over the coming months: November's U.S. Presidential election, Italy's constitutional referendum in December, Britain's plan to start talks on exiting the European Union in March and 2017 elections in Germany and France.

At the same time, signs are growing that the days of very cheap money are winding down.

The U.S. Federal Reserve continues to point to a 2016 interest rate rise in December. European and Japanese central banks are reluctant to signal any new monetary easing ahead, and sterling's Brexit-fueled devaluation of near 20 percent has aggravated the UK inflation picture, probably taking further Bank of England easing off the table.

Add a rebounding oil price that has almost doubled from January's trough as OPEC countries consider supply cuts next month, and you have a potentially toxic mix for debt markets.

As monetary pumping has lifted nearly all financial assets, a bond shock could force a dramatic repricing across the board. If pricey bonds and stocks get knocked over, there could be a dash for the exits to lock in gains in both before yearend.

There is ample room to fall. Of 23 assets that Reuters typically tracks for quarterly roundups of global markets, 17 are up year-to-date, many of them handsomely so. For a graphic, click on http://reut.rs/2doKMRd

"The chance of a major bout of volatility this year is rising," said Joachim Fels, economic advisor to Pimco, one of the world's largest bond funds. "Markets have been sedated and seduced by the low interest rate environment and dovish central banks. This paradigm will be tested, possibly soon."

TINA

In one measure of how expensive stocks and bonds have become, Bank of America Merrill Lynch reckons their relative price compared with real estate and commodities is its highest since 1926.

The limits of this gap may be at hand as political pressure to cut wealth inequality is driving policy away from the quantitative easing and negative interest rates that raised prices of financial assets, BAML told clients.

What's more, BAML's latest fund manager survey shows that bullish bets on bluechip stocks, investment grade corporate bonds in the United States and Europe, and low volatility strategies are the top three crowded trades of 2016. All are vulnerable to rising bond yields.

Some of the world's leading stock indices are at or close to their record peaks and valuations near their highest in a decade, despite lackluster corporate profits. http://reut.rs/2edc3rQ http://reut.rs/2eh85N5

Corporate earnings worldwide are expected to grow just 1 percent in 2016, according to Thomson Reuters data, a weak recovery from last year's fall.

Ongoing troubles at European banks, slowing growth in China and the impact of a strong U.S. dollar on emerging markets and commodities continue to mar the outlook.

Yet yield-starved investors have pushed blue chip stock prices to new highs by latching on to historically high relative dividend returns compared with near zero bond yields across much of Europe and Japan.

Traditional investment behavior has reversed, in that many funds have been investing in equities for income and in bonds for capital gains. For many this persistent buoyancy of equities is simply down to TINA or "There is No Alternative."

Analysts at Citi argue that there is less economic uncertainty than usual: forecasts for growth, inflation and interest rates are unusually stable. But that could create risk.

"This is problematic for investors. A perception of higher certainty creates consensus, consensus creates complacency and complacency creates risk, particularly when the consensus view is reflected in congested, consensus market positioning," Citi's Tina Fordham and Tiia Lehto wrote on Monday.

And if key readings of market volatility are any guide, these risks are nowhere near fully factored in.

Implied volatility on euro dollar <EUR1MO=>, the most traded exchange rate in the world, has been rarely been lower than current levels over the euro's 17-year lifetime.